February 5, 2008
Moody's Weighs Warning Labels For Its Ratings
By AARON LUCCHETTI
February 5, 2008; Page C1
In an acknowledgment that the system it used to rate billions of dollars of mortgage-related securities was potentially flawed, Moody's Corp. said it is considering a new way of rating those and other sometimes-volatile structured finance vehicles.
The credit-rating firm is considering an overhaul of its rating procedures that could include new labels to help investors distinguish collateralized debt obligations and other structured-finance investments from corporate bonds and Treasury securities.
One of the most significant changes being considered by the parent of Moody's Investors Service: a new, 21-point numerical scale to rate structured securities. Moody's familiar letter grades -- from triple-A to single-C -- would continue to be used for corporate and government bonds, including tax-exempt municipal debt.
More broadly, the ratings firm is trying to decide whether to add warning labels that essentially acknowledge the limitations of its ratings.
"We've been taking a hard look at the things we do," said Richard Cantor, a managing director at Moody's who co-wrote the four-page report released yesterday in which the ratings firm announced the possible changes.
This is the first time since the methodologies of Moody's and rival credit-rating firms came under attack this past summer that any of the firms has suggested it might change how it issues its hugely important ratings. The move also is an indirect admission that Moody's ratings didn't work right, even though the firm still insists some investors relied on them too much.
Standard & Poor's, a unit of McGraw-Hill Cos., said it is working on similar moves to shore up confidence in its ratings, though a spokesman declined to discuss details. A spokesman for Fimalac SA's Fitch Ratings said: "We're constantly looking to make sure our ratings are as productive as possible for investors."
The possible changes also show how Moody's is trying to rehabilitate its reputation while heading off more draconian changes that could be forced on credit-rating firms by lawmakers and regulators fuming over mortgage-bond downgrades criticized as too little, too late. Those downgrades helped exacerbate the credit markets' woes in recent months.
Regulators in Europe and the U.S. may welcome any change by Moody's. Federal regulators, led by the Securities and Exchange Commission, may even propose in coming months that certain distinctions be made for all structured finance ratings, according to a person familiar with the matter.
If Moody's goes through with any of the changes, investors are likely to tread more carefully before buying structured finance vehicles. That could reduce demand for such securities. But some Wall Street experts said the ratings firms should focus on doing a better job with the current system.
"This sounds like what a lawyer is telling them to do, rather than giving investors valuable information," said Thomas Atteberry, a fund manager at First Pacific Advisors. "If you're going to put a bunch of warning labels on the rating, I'm going to say, 'What is the value there?"'
Historically, Moody's has defended the idea of having the same letter-based approach for all the bonds it rates, saying investors prefer that approach. Recently, though, some investors have expressed interest in a separate ratings methodology for mortgage-related bonds, since they have proven to move in packs and to be prone to multinotch downgrades that indicate a rapid change in the overall view of their creditworthiness.
Moody's said some sophisticated bond-fund managers don't think it would be useful to have a different rating approach for structured finance. But those managers' clients -- pension funds and wealthy individuals -- have been concerned that some triple-A bonds act so differently from others.
Moody's said recently it has downgraded 252 triple-A ratings for CDOs sold in 2006 and 2007, or 22% of the 1,155 deals issued in that period. The average magnitude of downgrade was about eight notches.
Standard & Poor's has lowered its triple-A rating on 274 mortgage-related bonds and investments, or about 6.7% of the ratings it gave to these instruments issued from 2005 to the third quarter of 2007. More than 60 of these have been downgraded 10 or more notches to junk status, including Bear Stearns Mortgage Funding Trust 2006-SL1 and Home Equity Mortgage Trust 2006-5 in December. Many of the downgraded mortgage deals have plummeted in value, leading to billions of dollars in write-offs for financial firms.
In its report, Moody's said a "different rating scale for structured securities could provide greater clarity about differences" between types of bonds "and could encourage market participants to consider the potentially different characteristics of structured and nonstructured securities" in designing their portfolios.
In addition to using a new rating scale, Moody's also suggested the possibility of adding extra labels or warnings to ratings to indicate subtleties in the way mortgage bonds and other structured vehicles perform. This could include an "SF" designation after a rating or an extra volatility rating, such as "v2."
"It would be a heads up for the investor that they might want to look more closely, view the product differently and make sure they're comfortable with the way they're treating it," Mr. Cantor said. Moody's is open to carrying out any of the five options outlined in its letter, though no decision will be made until the firm hears what investors think, he added.
Moody's has attempted some industry overhaul in light of the mortgage market's problems. In the fall, it called for better due diligence in the mortgage-underwriting process.
Moody's previous calls for change haven't resulted in dramatic action, in part because the firm was making recommendations on how others in the mortgage industry conducted themselves. A spokesman said dialogue with the industry continues on those topics. Moody's has more direct input over these new issues because they deal with its own rating process.
At the very least, Moody's will publish papers that warn investors about the unique performance features of mortgage bonds.
"Moody's doesn't believe the status quo is acceptable," Mr. Cantor said. "We're doing all we can to improve our methodologies."